The amount of cash generated and used by a company during a given period. Cash flow is calculated
by either adding or subtracting noncash charges (such as depreciation) to net income. It can be attributed
to a specific project or to a business as a whole. Maximizing annual depreciation deductions through cost
segregation reduces taxable income thereby generating increased cash flow.
The process of evaluating a commercial or residential rental property and
identifying and reclassifying eligible non-structural assets from longer recovery periods (typically
27.5-years or 39-years) to shorter recovery periods (typically five, seven or 15-years). Accelerating
the depreciation of these personal property assets can result in a reduction of current tax liability
thereby generating increased cash flow.
Cost Segregation Audit Techniques Guide
Developed to assist Internal Revenue Service examiners in the review and examination of cost
segregation studies. The primary goals are to provide examiners with an understanding of why cost
segregation studies are performed for federal income tax purposes, how cost segregation studies are
prepared, and what to look for in the review and examination of these studies. All properly documented
cost segregation studies should conform to this guide.
Cost Segregation Eligibility
The eligibility requirements for a cost segregation study include: investment property or property
used for the operation of a business (whether a commercial or residential rental property) constructed
since 1986; an existing property that has been renovated, expanded or restored; or an existing property
that has had leasehold improvements performed. Additionally, since the fundamental concept of cost segregation
is to accelerate tax deductions for depreciation, thereby reducing income tax liability, the property owner
needs to be an income tax payer.
Cost Segregation Study
A tax and engineering analysis of any real estate holdings including leasehold improvements. It is designed
to accelerate the tax deductions for depreciation by reclassifying eligible fixed assets to shorter recovery
periods. A cost segregation study identifies and segregates those assets, assesses their value and determines
the resulting accelerated depreciation. Relevant IRS guidelines should be adhered to and thorough documentation
Cost Segregations Study Approaches
There are several different approaches to conducting cost
segregation studies, including:
Engineering Approach From Actual Cost Records This is the most methodical and accurate
approach to cost segregation, relying on solid documentation and minimal estimation. Construction-based
documentation, such as blueprints, specifications, contracts, job reports, change orders, payment requests,
and invoices, are used to determine unit costs. The use of actual cost records contributes to the overall
accuracy of cost allocations, although issues may still arise as to the classification of specific assets.
Detailed Engineering Cost Estimate Approach The detailed engineering cost estimate approach (or detailed
estimate approach) is similar to the detailed cost approach. The difference is that the detailed estimate
approach estimates costs, rather than using actual costs. This approach is used when cost records are not
available or for an acquisition when the purchase price must be allocated.
Survey Or Letter Approach The survey or letter approach is an alternative method for estimating costs.
In this approach, contractors and subcontractors are contacted via a survey or letter to provide information
on the cost of specific assets that they installed on a particular project.
Residual Estimation Approach The residual estimation approach is an abbreviated method in which only
short-lived asset costs (e.g., 5- or 7-year property) are determined. Although this method is simpler and
less time consuming than the engineering approaches, it can also be less accurate.
Sampling Or Modeling Approach The sampling or modeling approach uses a created model (or template) to
analyze multiple facilities that are nearly identical in construction, appearance and use (e.g., fast
food chains and retail outlets). The use of sampling minimizes resources and costs compared to conducting
studies on all properties.
"Rule Of Thumb" Approach Some cost segregation studies are merely based on a "rule of thumb" approach.
In general, this approach uses little or no documentation and is based on a preparer's "experience" in a particular
Cost Segregation Study Process
In a properly documented cost segregation study, an engineer will conduct a site study and analyze
architectural drawings, mechanical and electrical plans, and other blueprints when available to segregate
the structural and general building electrical and mechanical components from those linked to personal
property. Cost specialists determine the value of all assets eligible for cost segregation, using the most
widely accepted sources of construction cost information, such as the services of RS Means. Accounting and
tax experts then compile relevant tax law and IRS guidance in order to support the eligible asset reclassification.
In addition, appropriate depreciation schedules are prepared which will then be incorporated into the client's
tax return by their CPA.